What is an illiquid investment and should you invest?

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Holly Black: Welcome to the Morningstar series, "Ask the Expert." I'm Holly Black. With me in the studio today is Fund Analyst, David Holder.


David Holder: Hi, Holly.

Black: So, today, we're here talking about illiquid assets. They've been quite a high profile recently with the suspension of the Woodford Equity Income Fund. And I think a lot of investors may now be worried if they have any exposure to these assets. So, let's start with what is an illiquid investment?

Holder: An illiquid investment is something which there is not a ready market for on a daily or intraday basis or even in fact, a monthly basis or quarterly basis. These are assets which are – whilst they might be valued in terms of a fund, that value may not actually bear much reality to the value you might get when we try and sell or buy an asset. And so, the way that I would think about this is, a house. If I buy and sell a house, it can take many months for that deal to be completed. So, houses and residential and commercial property you would list amongst illiquid assets.

Black: So, it's basically anything where you can't buy and sell it on the stock exchange in an instant?

Holder: Pretty much, yeah. I mean, of course, if you think about it, you've got – there's a two-way market involved with any asset. So, if I wish to buy an asset or I wish to sell an asset, I need to buy it from someone, or I need to sell it to someone. And in those cases where there's illiquid assets, there's not perhaps as much transparency or visibility on the assets and there's quite a lot of due diligence that needs to be carried out. And so, therefore, going back to the analogy about a house, you need a surveyor, et cetera, et cetera. And so, there's a number of reasons why the price isn't quite as straightforward to ascertain. It might be for a stock that is listed intraday on the market.

Black: And despite all of these risks and complexities, this has been a really popular area with investors over the past few years. Why is that?

Holder: It's been popular because I think principally the search for income, interest rates have been extremely low. Many illiquid alternative asset classes can give you quite high levels of income, certainly higher than you'd be getting on deposit or in conventional assets. And so, I think, there's been quite a strong tailwind for some of these assets that are providing better levels of income for investors. And of course, also, there's the issue of uncorrelated returns. And so, many of these asset classes, the drivers of returns will be sort of different from those that you will see in generic equity or bond portfolios.

Black: I think there's also the perception that with some of the unquoted companies there's the chance to get some really high growth if you invest before they list on the stock market.

Holder: I think that's what attracts people to unquoted investments. Unquoted equities are obviously companies that operate as any company does but away from the day-to-day or quarterly scrutiny of the market. So, in the States, for example, companies need to file their quarterly returns, how they are doing, their sales, et cetera. And so, very often what you hear is that management are so preoccupied with the short-termism that they forego slightly better longer-term strategic options that they could take just to keep the market happy on a quarterly basis. And so, therefore, if you take away those problems from company management and let them do what they do best, then I think you are able to capture better long-term growth. And indeed, you can think about this in terms of illiquidity premium. And so, you're expecting higher levels of returns for a company that is more growth-orientated and doesn't necessarily have the ready market that you might have for a quoted company.

Black: So, something we've seen in the last couple of weeks is the long-term nature of these investments doesn't really marry up when you are accessing through a fund. So, perhaps the best way to get access is through an investment trust instead. Would you agree with that?

Holder: I would agree with that. I think it makes entirely imminent sense. There's a liquidity mismatch between the daily dealing for an open-ended OEIC or unit trust versus the many months that it might take to sell an asset within, an illiquid asset within an open-ended structure. This has always been a problem for investors how to access these types of investments. And the closed-ended structure is particularly attractive for these types of asset classes and indeed we've seen much of the primary issuance in closed-ended world into these alternative asset classes, whether it's infrastructure, specialist lending. Less so in hedge funds these days and of course, always in private equity. They are an ideal structure. Because it allows the fund manager to get on with managing the assets without having to worry about the inflows or outflows that they will otherwise see within an open-ended structure.

Black: So, what would you say to anyone considering investing in this area as some top tips?

Holder: Well, I would think, obviously, there's always – the main point is, do your due diligence on the assets that you're buying. There will be valuations that are published by the company. Those valuations, obviously, we know will be backward-looking. There will be a fixed point in time that may not necessarily reflect the prices that you could get for those assets at the moment. It's a very interesting area for investment. It's not without its pitfalls though.

Black: David, thank you so much for your time.

Holder: Thank you, Holly.

Black: And thanks for joining us.

This report appeared on www.morningstar.com.au 2019 Morningstar Australasia Pty Limited

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